The Effects of General Inflation and Idiosyncratic Cost Shocks on Within-Commodity Price Dispersion: Evidence from Microdata

Abstract

This study investigates the dispersion of price levels within highly dis-aggregated markets by examining plant- level product records from the U.S. Census of Manufactures. The paper estimates the effects of inflation on price dispersion through cross-sectional variation in the drift rate of average target prices within a market. In a menu cost model, where sellers try to keep posted prices close to desired prices, an increase in the price of an important input raises the desired output price in much the same way that an increase in general inflation raises target prices. We measure the drift rate of the desired price from the average growth rates of composite input price indices. We then compare the drift rates of the desired prices with the dispersions of prices within markets. With microdata, we also disentangle the effects of aggregate and idiosyncratic shocks to target prices. In menu cost models, a higher variance of total shocks leads to a widening of adjustment bands, and consequently an increase in dispersion. Higher aggregate variation, however, may also lead to clumping as in Caplin-Leahy (1991), leading to lower dispersion. Higher variation also reduces the signal-to-noise ratio in imperfect information models, and it reduces the information content in a single observation in search models such as Tommasi (1992). Lower information content also may increase price dispersion in these models. Overall, our results are significant; we explain about one-fifth of the variation in the amount of price dispersion across different commodities. In general, we find that the higher the drift rate of the desired price of a given commodity, the larger the amount of price dispersion. The standard deviation of idiosyncratic shocks also is positively correlated with the degree of price dispersion, while the standard deviation of aggregate shocks is negatively correlated with price dispersion.

JEL Classification: E43